Minimizing the Income Tax on the Receipt of Lump-Sum Social Security Benefits

Sometimes a taxpayer will receive Social Security benefits in one lump sum. A taxpayer might have to pay income taxes on up to 85 percent of these benefits. However, a taxpayer may make an election under Section 86(e) of the Internal Revenue Code to minimize the income tax on the receipt of the lump-sum Social Security benefits.

Why would a taxpayer receive lump-sum Social Security benefits? A taxpayer could have been receiving Supplemental Security Income (SSI), which is tax free. Then, the Social Security Administration determines that the taxpayer should have been receiving Social Security disability benefits for the last several years instead of SSI. Another reason that a taxpayer could receive Social Security benefits in one lump sum is that the Social Security Administration may have initially denied the individual's application for Social Security disability benefits, but the individual wins those benefits on appeal.

Social Security benefits are not taxable for taxpayers with relatively low amounts of adjusted gross income. At moderate levels of adjusted gross income, 50 percent of the Social Security benefits are taxable. At high levels of adjusted gross income, 85 percent of Social Security benefits are taxable.

This graduated system for including Social Security benefits in gross income and the progressive nature of income tax rates can have a very bad effect on individuals who receive lump-sum Social Security benefits. Such individuals might have to pay a much larger amount of income taxes than they would have if they had received the Social Security benefits when they should have received them. If the taxpayer does not take action to make an election allowed by Section 86(e) of the Internal Revenue Code, that is what will happen.

Sometimes the taxpayer does not receive any cash for the lump-sum payment. For example, if the taxpayer had been receiving SSI and the Social Security Administration determines that the taxpayer should have been receiving Social Security disability benefits, the Social Security Administration will reduce the disability benefits by the amount of the SSI paid to the taxpayer. The taxpayer will receive a Form 1099-SSA showing the amount of the lump-sum Social Security disability benefits and yet the taxpayer received little, if any, cash.

Section 86(e) of the Internal Revenue Code allows a taxpayer who receives lump-sum Social Security benefits to elect to include in gross income only the sum of the Social Security benefits that the taxpayer would have included in gross income in prior years if the taxpayer had received the benefits in the years to which the lump-sum payment is attributable. A taxpayer may also make the election if the taxpayer received Railroad Retirement benefits in one lump sum.

Section 86(e)(2)(B) states that the taxpayer should make the election in the manner prescribed by the Secretary of the Treasury in regulations. However, the Secretary of the Treasury has not issued any regulations under Section 86. Once a taxpayer makes the election, the taxpayer may not revoke it with the consent of the IRS.

Because no regulations exist that prescribe the manner of the election, a taxpayer should make the election according to the guidance the IRS provides in IRS Publication 915, "Social Security and Equivalent Railroad Retirement Benefits." IRS Publication 915 has helpful worksheets and other information about making this election. Taxpayers who received Social Security benefits or Railroad Retirement benefits in one lump sum should consult IRS Publication 915 and determine whether the election will reduce their taxes.

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